Wednesday, September 24, 2008

End of free-market capitalism?

What will be US President George W Bush’s legacy to the world: an unfinished war on terrorism and global financial meltdown? In a subdued voice all that he could say initially was: “The American people are concerned about the situation in our financial markets and our economy, and I share their concerns.” But of course the government is doing much more than simply watching Wall Street blow up. Earlier the government took control of Fannie Mae and Freddie Mac, the government-sponsored gigantic home finance agencies, not only to help promote market stability and to ensure a housing market recovery but also to assure foreign debt buyers that their investments were safe. The Federal Reserve and the Treasury acted not too soon to prevent the collapse of one the world’s biggest financial companies, the American International Group (AIG), a development that could have given a fatal blow to global financial markets.

When a $13-14-trillion economy shakes, it causes a global earthquake. No one is even trying to stop the spiral of gloomy news. The mighty dollar has been falling in value, causing pain and anxiety. Consumer confidence is down and people are holding back from spending on durable goods such as cars, appliances, business equipment, electronic equipment, home furnishings and fixtures, and house wares and accessories. There are fewer buyers of houses even though house prices have declined substantially during the last two years. To stem the slide, Mr Bush and Congress came up with a $152-billion stimulus plan under which most taxpayers got from the government $300 to $1,200; but consumer spending did not lift the sagging economy.

Only six months ago, Mr Bush ritualistically said, “We believe in a strong dollar policy and we believe, and I believe, that our economy has got the fundamentals in place for us to be, to grow and continue growing more robustly, you know, hopefully more than we are growing now.” But the global market does not listen to Uncle Sam any longer. In fact when Federal Reserve Chairman Ben Bernanke warned during the second day of his semi-annual testimony before a congressional committee that even some banks might fail due to bad real estate loans, the stock market shrank in mortal fear. And no one believed him when he said that the overall banking system was in good shape, when Merrill Lynch had gone begging for billions of dollars of cash infusion from foreign government-controlled sovereign wealth funds. The levers of political power in Washington DC have little effect upon Wall Street, which runs on its own convoluted logic, alternating between illogical exuberance and uncontrollable panic.Today uncertainly and fear rule, though the recent massive infusion of liquidity by the Federal Reserve and European and Japanese central banks have firmed up the market for the time being.

It is rather strange that for Americans prosperity is so much tied up with the economics of the housing market. Market finance, in spite of all econometric models and theorising by economists, is essentially nothing more than a herd psychology of fear and hope.

Due to poor home mortgage lending practices verging on greed, banks started giving loans on low adjustable interest rates to people with poor or even no credit, hoping that since home prices were going up borrowers would re-finance their loans based on increased home equity.But sometime in this hope-and-faith-based financial system the weakest link snapped, lenders and borrowers started losing mutual trust, and whatever earlier seemed to be a blooming housing market turned into an empty myth, a speculative bubble that burst resulting in stampede and panic.

As the low initial interest rates on adjustable subprime mortgages were re-adjusted, borrowers defaulted and foreclosures began to rise. Even for the good borrowers, interest rates went up. Falling housing prices created negative equity, which made the mortgage relative to the value of the house much greater. Some people who bought houses with small or no down payment simply walked away, because their houses were worth much less than they originally bought for. There is nothing more humiliating for a person than losing his home to bank foreclosure, but many people swallowed their pride.

Foreclosures added to the market glut, so home prices kept sliding down and Americans began to feel less surefooted. Spending on non-essential goods, going to restaurants, buying a new a sofa, for example, seemed less necessary to many; and they postponed buying a new auto for another six months or even year. Banks shrank in fear lest consumers defaulted, so they pushed up the lending bar thereby reducing credit availability, which adversely affected economic activity further. So when Mr Bush thought that a tax refund would bring back spending and stimulate the economy, it was on the assumption that millions of small trips to malls would have an escalating effect, preventing the much-feared nightmare of recession from becoming a reality.

But neither he nor his advisors understood what was happening until they saw even trillion-dollar financial institutions with global tentacles like Freddie Mac, Fannie Mae and AIG in danger of being sucked into the black hole.Now that the unbridled trust in the self-correcting mechanism of free-market capitalism has been belied, the US government’s massive intervention to save the financial system from total collapse, you might say, is no different from what an authoritarian government, socialist or capitalist, would have done in similar circumstances.

The point is that in an increasingly globalised financial system, the role and the authority of the government, instead of decreasing, has become more important than ever. If the state ~ the ultimate saviour ~ were to wither away, who would come up with a trillion-dollar rescue package to mop up the toxic assets created by global corporates?